Description

Investment: (Potential Return 150%)

We are recommending going long a stub position in Gruma Corporation (GRUMAB MM) due to its dominant position in a rapidly growing market, potential for significant margin expansion, and an undervalued asset base that is being obscured by a large public holding on its balance sheet. Gruma Corp is the world's largest tortilla and corn flour producer with a near monopoly on production in Mexico and controlling marketshare in the US. Over the past year the tortilla and corn flour industry has faced substantial margin pressure as rising corn, wheat and energy costs have outpaced price increases on finished goods. We are confident that this will prove to be a prudent buying opportunity as the company should start to realize the benefits of its current price increases in the US and its future increases in Mexico. We believe the stub is unjustifiably cheap at 4.4x 2008 EV/EBITDA and that upside of around 150% could exist. 

For its core assets we feel the market is severely undervaluing Gruma’s US division. While the company historically focused it operations on emerging markets the US now accounts for more than 60% of its profits and a large portion of its future growth. Through its extensive DSD (direct store delivery) network Gruma has built one of the only nationally branded products focused on the rapidly growing Hispanic population in the US. Mission Tortillas have become a household name and have allowed the company to branch out into other areas of production (chips and wraps) with limited expense. The company has signed agreements with almost every large scale supermarket chain to obtain end cap isle space and Gruma has become Frito Lay’s only viable competitor in tortilla chips.

In its non core assets we believe the company’s 9.86% equity investment in Grupo Financiero BaNorte (GFNORTEO MM) is being overshadowed by the current short term operational issues in Gruma’s core business. Because this investment is held under the equity method the true market value is not fully reflected on the company’s balance sheet. By using a discount for tax affects and marking to market the position at current prices BaNorte accounts for more than half of Gruma’s market cap. As we have no view on Mexican banking we have chosen to short out the position in order isolate the stub.

 

Price: 35.5

Market Cap: 17.376 B (1.597 B USD)

Net Debt: 6.830 B (.627 B USD)

 

P/B (stub):  .85 x

Dividend Yield: 2.3%

EV/EBITDA 07 (stub): 5.8 x

EV/EBITDA 08 (stub): 4.4 x

Estimated 5-year Earnings CAGR (07-12): 45%

*Our stub definition includes the mark to market value of Gruma’s 9.86% holding in Grupo Financiero Banorte (GFNORTEO MM) less tax effects

*To create the stub position we shorted .348 shares of BaNorte for every share long of Gruma

 

 

Industry Background:

            The tortilla industry can be broken down into two distinct markets; the United States and Mexico. Mexico given its growth profile is considered a mature market. Demand roughly increases inline with GDP and consumers view tortillas as an essential dietary staple. While there are several hundred if not thousands of local “tortillarias” (producers) there are only a handful of corn flour suppliers. In Mexico, Gruma controls approximately 70% of the corn flour market and operates in a relatively benign competitive environment.

The United States given it’s ever diversifying culture and rapid influx of immigrants has seen a boom in demand for tortillas over the last decade. Consumption in this market has been growing at a rate of 5-8% per year. Furthermore, the consumer is willing to pay a premium for branded products. As such Gruma has spent the better part of two decades vertically integrating from a traditional corn flour producer to the largest tortilla manufacturer and distributor in the US (selling its products under its Mission and Guerrero brands).

 

Overview:

As mentioned above the company’s margins have temporarily been affected by rising raw material cost over the past year. While Gruma has been able to pass through most of the cost to the consumer in the US (once in July 2006 and then again in December 2006) the situation in Mexico has been very different. Even though Gruma effectively controls the corn flour market it has received a lot of political and social pressure to temporarily cap pricing. President Calderon entered office just in time to deal with the “tortilla crisis” and because numerous local and state elections are being held from now until September it is our feeling that the government would like to sidestep this issue until the party has gained stable control. We are confident that over the next six months margins should normalize as the company begins to increase prices in Mexico.  Both Gruma and high level government officials have publicly stated that prices will be allowed to rise in August as current agreements end.

Historically Gimsa, Gruma’s Mexican subsidiary, has been the focus of the company’s operations. This division produces the principal input for corn tortillas (corn flour) and accounts for approximately 25% of revenues and 30% of profits. Over the last decade there has been a shift away from the need to expand in this market as penetration, maturity and consolidation have created a stable growth environment. Currently the company is using the cash flow generated from this division to fund further expansion in the US.

Gruma’s US division now accounts for 55% of the company’s total revenues and approximately 60% of its profits. Over the last few years this division has experienced rapid top line growth, 10-15% annually, driven primary by regional expansion, strategic acquisitions and high organic growth. It is management’s intension to continue to focus most of its efforts and capital in this market. Due to its size (33% marketshare) and scale Gruma is viewed as a natural industry consolidator.

Finally we feel that Gruma’s stock does not appropriately reflect its holdings in Grupo Financiero BaNorte. With a market cap of approximately 103 billion pesos Grupo Financiero is Mexico’s largest publicly listed bank (GFNORTEO MM). Gruma originally acquired this position during the privatization of national banks and carries it at 2.7 billion pesos on its balance sheet. Over the last year and a half the company has been able to use previous asset write downs to shield share sales from any capital gains tax. Management has commented that they do not expect to incur taxes on this year’s 1.63 billion pesos sale of BaNorte shares. Longer term the company should incur between 12-15% capital gains tax on the remaining position.

 

Thesis:

            We believe that over the next six to twelve months there will be several positive catalysts for the stock. First we expect EBITDA margins to normalize in Mexico by the beginning of 2008, rising from 5% to 13%. Based on our channel checks we believe Gruma plans to increase prices over a 4 or 5 month period. This will allow the company to regain the margin lost by any increases in raw material costs. In the interim the company is likely to receive corn at a lower procurement cost as the government has begun to subsidized transportation and has provided incentivize for the farmer to rapidly expand production of white corn in the Sinaloa region.

In the United States we expect margins to continue to improve as the company cuts cost, consolidates new regions and executes on its planned price increase over the next few months. Under conservative assumptions Gruma should be able to return its US EBITDA margins to 12% by early 2008. In mature markets in the US the company is currently operating at 15 to 16% EBITDA margins. Due to accelerated growth into new regions (mainly the North East) aggregate margins have been depressed as plants are brought onto production. Once growth in the new markets slows and the company focuses on consolidation it is very likely that group margins will rise to mature market levels. Although this is unlikely to happen in the short term management is confident in this longer term goal.

The final major catalyst is the liquidation of the BaNorte asset. Over the last few years the Gonzalez family (controlling shareholder of Gruma) has been able to gain control of BaNorte without the use of Gruma’s holding. This in affect has freed the company to strategically liquidate the position. Since then the company has slowly started to sell off the asset in the open market. This year the company plans to realize approximately 1.63 billion pesos ($150 million USD) from the sale of its holdings. With the cash raised the company is accelerating its capex program in the US. To us this is a clear indication by management to focus on its core operations and unlock a significant amount of value for the company.

 

Sum of the parts Valuation:

 

 

Business               Revenue 2008       EBITDA Margin                   Multiple                 Value Per Division              

Gruma (US)            21,032                     12%                                        9                              22,714

Gimsa (Mex)          8,135                       13.5%                                     6.5                           7,138

Gruma (Ven)          3,337                       5%                                          3                              500

                                                                                    Total                       31,088

 

Current Shares of BaNorte: 199,009,133

Price per share: 52

Mark to Market on Shares (MXN): 10,348

Market value to Gruma after tax effect and asset sale (MXN): 7,474

 

*to calculate the stub position below we used our forecasted fair value for Gruma and assume no change for the bank shares

 

Using this potential future value on Gruma

Current shares held of BaNorte:        199,009,133

Shares to be sold this year:                                31,384,615

Shares of BaNorte end of 2007:         167,624,487

Ratio: 1 long share of Gruma receives .348 shares of BaNorte

 

 

                                                                Value Per Share                    Weighted Contribution       Value to Stub

Calculated Value of Gruma:                                61.3                                         100%                                      61.3

Current Value of BaNorte                                   52                                            34.8%                                     18.1

 

Current Stub Value (in USD):                             1.60

Stub Fair Value (in USD):                                    3.97

Potential Return:                                                148%

 

 

 

Other operations: currently applying zero value under our conservative assumption

 

(In millions)

Value of Gruma:                                    31,088

Value of BaNorte:                 7,474

Net Debt:                                               6,031

Minority Interest:                                 3,000

 

Estimated value of equity:                 29,532

Shares outstanding:                            482

Value per share:                                    61.3

Current Price:                                        35.5

Potential Return on Gruma: 72%

 

Conclusion:

Over the next 12 months we believe the normalization of operating margins, liquidation of non core assets and the continued sale of the BaNorte shares should lead to significant upgrades by analysts. Furthermore, we feel that the company will continue to create shareholder value as the operational focus is shifted to expansion and consolidation in the US. Over time a significant majority of revenue and profits will be generated from these operations and management has expressed interest in relisting the company in the US.

 

Catalyst:

• Sale of BaNorte shares
• Increased pricing in August for Mexican division
• Improved operating results in the US and further price increases
• Further liquidation of non core assets

 

Risk:

• Soft commodity prices continue to rally
• Price increases by the company stunt top line growth
• The Mexican government does not follow through on its promise to allow the corn flour industry to operate in a free market 

Comp Group:

Ebro Puelva (EBRO SM Equity)

Heinz (HNZ Equity)

Kraft (KFT Equity)

Grupo Bimbo (BIMBOA MM Equity)

Catalyst

• Sale of BaNorte shares
• Increased pricing in August for Mexican division
• Improved operating results in the US and further price increases
• Further liquidation of non core assets